by Michael Mussa, Peterson Institute for International Economics
Testimony before the Subcommittee on International Trade and Finance
Senate Committee on Banking, Housing, and Urban Affairs
October 14, 2002
It is a pleasure to participate in this timely hearing concerning the difficult economic situation in Latin America and the efforts of the United States and the international community to ameliorate these difficulties.
This year, Latin America is suffering its worst economic performance in nearly two decades, with real GDP for the region projected to drop by 2 percent—the largest decline since the darkest days of the debt crisis in 1983. Argentina is an economic catastrophe, with real GDP expected to fall a further 15 percent this year to roughly 25 percent below its 1998 peak. Uruguay is also in a severe and prolonged recession, facing a decline of another 8 to 10 percent in this year's output. Hit by domestic political turmoil, Venezuela's economy will probably shrink about 5 percent this year.
Other countries in the region are not faring as badly; but none are doing well. Brazil, which has the region's largest economy, will be lucky to achieve 1 percent real economic growth this year—following upon 4 years where the average annual growth rate has been well below Brazil's potential. More importantly, Brazil now teeters on the brink of a major financial crisis that—if not averted—would push next year's growth to sharply negative. Even the region's best consistent economic performer, Chile, faces another year of distinctly sub-par growth. And Mexico, the region's second largest economy and the Latin American economy that has by far the most important economic linkages to the United States, will probably grow by less than 2 percent this year and remains at significant risk if the US economic recovery loses forward momentum. Thus, as general background for this hearing, it is relevant to recognize that the present economic situation in all of Latin America is not good, and there is considerable concern that it may not get much better anytime soon.
Of course, several important factors have contributed to Latin America's present economic difficulties and to the risks going forward, with the most relevant factors differing considerably across individual countries. The global economic slowdown and the weakening of many commodity prices have had a negative impact on exports from the entire region. Diminished inflows of foreign direct investment to Latin America have also partly reflected the weaker worldwide investment climate. Meanwhile, conditions in world financial markets have turned distinctly less hospitable toward emerging-market borrowers—a factor of particular importance for relatively heavily indebted Latin American countries. And, negative spillovers within the region have also been important for some countries, most notably the severe negative consequences for Uruguay of the economic catastrophe in Argentina.
Despite the clear importance of such external factors, however, the most important causes of Latin America's present distress lie in domestic economic weaknesses and in how these weaknesses have interacted with adverse external developments. This is especially so in Argentina where (as I have argued elsewhere) the combination of a very rigid exchange rate regime and persistent imprudence in fiscal management ultimately led to a disastrous economic and financial crisis.1 A similar story applies to Brazil's present predicament. A large build-up of net public debt (from 30 percent of GDP in 1994 to over 60 percent of GDP today) and a large external financing requirement (relative to merchandise exports) for the combined public and private sectors have made Brazil particularly vulnerable to an adverse change in financial market sentiment that now threatens to make sovereign default and/or systemic private default a self-fulfilling prophecy. Indeed, even for Uruguay where adverse external shocks have undoubtedly played a particularly large role in present difficulties, the high vulnerability to these adverse shocks was seriously exacerbated by the large prior build-up of public debt and the substantial foreign exchange risk exposure of Uruguay's financial system.
Clear recognition that Latin America's present difficulties and challenges reflect primarily domestic weaknesses and vulnerabilities that have been significantly exacerbated by adverse external developments is essential to understanding the particular issues that are the main focus of this hearing. The international economic and financial system does not function perfectly, and its malfunctioning is partly responsible for the instability now gripping much of Latin America. Confusion and inconsistency in the policies of the US government and of the official international community (particularly the International Monetary Fund) have, in my opinion, contributed to the malfunctioning of the system and, accordingly, have made the problems of Latin America somewhat more difficult than they might otherwise have been. Conversely, a more sensible and consistent set of policies of the international community to address potential and actual crises in emerging-market countries—with credible leadership and support from the United States-could help Latin America emerge more rapidly and successfully from its present travails. Nevertheless, the principal tasks of managing the present difficulties, reducing the likelihood of their recurrence, and laying the foundation for a more prosperous future necessarily lie with Latin Americans themselves.
With this general principle in mind, I turn to address three specific issues raised in the letter of invitation to this hearing. First, what is my understanding and assessment of the US Administration's policy concerning so-called "bailouts" of emerging-market countries facing actual or potential financial crises, especially as now it relates to Uruguay and Brazil? Second, what is my evaluation of the approach that the IMF has taken in the cases of Uruguay and Brazil, in comparison with that adopted in the recent case of Argentina? Third, what should the international community attempt to do about problems of sovereign (or systemic) bankruptcy?
US Policy Toward Large-Scale Official Support
Perhaps there is, somewhere, a careful explanation of the present US Administration's general policy toward official financial support for emerging-market countries facing financial crises. Perhaps this statement somehow rationalizes the rhetoric, which suggests that the policy is to oppose "large-scale bailouts" and the facts, which show actual Administration support for official support packages on a scale and at a pace that dwarfs past efforts in this area. As a more than casual observer of these matters, however, I am befuddled by the glaring inconsistency between the Administration's words and actions; and I am far from the only one to suffer this confusion.
There has been little ambiguity about the Administration's rhetoric. In line with the analysis and recommendations of the majority of the Meltzer Commission, even before it took office, many of those who now hold positions of responsibility for economic policy in the present US Administration voiced their opposition to "large-scale bailouts" of countries facing financial crises and of these countries' creditors. After a year and a half in office, the Administration's rhetoric on this issue has changed little—beyond the recognition that there may be "special cases" where large-scale official support may be appropriate and that new mechanisms for dealing with sovereign bankruptcies should be implemented or at least studied.
The facts, however, belie this rhetoric. Within barely three months of taking office, the Administration supported a large expansion (about $10 billion) of the already significant official support package for Turkey from the International Monetary Fund. This raised IMF support committed to Turkey to over 1,500 percent of its IMF quota, in comparison with a normal (cumulative) access limit of 300 percent of quota. Nine months later, after the tragedy of September 11 emphasized the geopolitical importance of Turkey, the Administration endorsed a further massive expansion of IMF support for Turkey (about another $12 billion). This raised IMF support committed to Turkey to about $31 billion or roughly 2,800 percent of Turkey's IMF quota. In absolute amount, as a ratio to IMF quota, and relative to Turkey's GDP (of about $200 billion), this was by far the largest amount of IMF support ever committed to a single country up to that time.
In August 2001, the Administration supported an $8 billion increase in IMF financing committed to Argentina, on top of the $20 billion of official support (from the IMF, World Bank, IDB, and the government of Spain) that had been committed in early January. This raised the ratio of official support committed to Argentina to GDP to a level that was, up to that time, exceeded only by the combined support committed by the US Treasury and the IMF to Mexico in early 1995.
In September 2001, the Administration also participated in the IMF decision to extend about $15 billion in precautionary financial support to Brazil, in light of risks of contagion from the deepening crisis in Argentina. The committed IMF support, available for disbursement over a period of 15 months, amounted to 400 percent of Brazil's IMF quota, compared with a normal annual access limit of 100 percent of quota. When, in the face of sharply deteriorating market sentiment, Brazil drew the bulk of this previously committed support in July 2002, Secretary O'Neill initially indicated strong US opposition to any further IMF support for Brazil. This opposition, however, was soon reversed; and in August the US Administration supported the commitment of an additional $30 billion of IMF support for Brazil, raising total committed IMF support to a new absolute record for a single country (but as a ratio to Brazil's GDP only about half that of Turkey).
For Uruguay, an IMF program with about $750 million of committed financing (about 200 percent of Uruguay's IMF quota spread over two years) was established in March 2002, succeeding an earlier program with about $200 of committed support. It soon became apparent, however, that this moderate level of support was woefully inadequate to meet a crisis involving massive withdrawals from Uruguay's banks and corresponding capital outflows. With strong encouragement from the US Government, official support committed to Uruguay has now been raised to $3.8 billion or about 20 percent of Uruguay's GDP. This puts little Uruguay at the top of the league table—displacing Turkey—as the country with the highest ratio of committed official support to GDP.
It might reasonably be argued that geopolitical considerations, especially in the aftermath of September 11, make Turkey a special case that merits significantly larger official financial support than would normally be appropriate-just as geopolitical considerations plausibly argued for somewhat special treatment of Russia during the 1990s. However, it is difficult to see how important geopolitical considerations weigh in the case of Uruguay. More generally, with six cases during its first 20 months in office (Turkey in February 2001, Argentina in August 2001, Brazil in September 2001, Turkey again in February 2002, Uruguay in June and again in August 2002, and Brazil again in September 2002) in which the Administration has endorsed large international support packages for emerging-market countries, it is nonsense to suggest that the Administration has a consistent policy of opposing such packages.2 The Administration's rhetoric says something that its actions strongly contradict.
Has this inconsistency done real damage? I fear that it has, in at least three ways.
First, officials in other countries have been confused and, in some cases, offended by the inconsistencies in US rhetoric and actions. Quite rightly, many in Brazil (and many elsewhere in Latin America) took umbrage at Secretary O'Neill's remarks this summer criticizing official support for Brazil as a waste of the hard earned money of US citizens to finance capital outflows from Brazil to Swiss bank accounts. Brazil has always repaid its official financial support—so that there is no reason to suggest that such support, whatever it might be used for, ultimately comes at the expense of US citizens. Moreover, this summer Brazil was facing severe pressures on its currency because of capital outflows related to a general decline in market confidence. No doubt, this included capital outflows by Brazilian residents; but it also primarily reflected cutbacks in external credits to Brazil and a fall off in direct foreign investment into Brazil. In this situation, negative comments by the US Treasury Secretary were certainly not helpful in restoring confidence-even if they were not a principal cause of Brazil's difficulties.
Second, for the international community to play a constructive role in dealing with emerging-market financial crises, it needs to behave in a reasonably predictable manner and in accord with a reasonable set of principles and policies. This is essential for both the governments of emerging-market countries and for the creditors of, and investors in, these countries (foreign and domestic) to be able to function in a responsible and stabilizing manner. Obviously, circumstances will differ in individual cases, and no precise blueprint can be established for how all possible contingencies will be handled. Some amount of "constructive ambiguity" may also be useful. However, the international community needs to set reasonable rules of the game that can be understood by its various participants—or the already difficult problems of emerging-market financial crises will be even more difficult. In this important area of international affairs, as in most others, constructive leadership from the US government is essential. Ideologically based policy rhetoric that is fundamentally and transparently contradicted by policy actions does not supply such leadership.
Third, actions speak louder than words; and judging by the Administration's actions, there is a relatively wide array of circumstances where large packages of international financial support (beyond the normal access limits of IMF support) need to be considered as part of the response to emerging-market financial crises. In what circumstances should such support packages be considered? How should they be structured? When should they be augmented? When should they be terminated? These are critical questions of judgment that the international community needs to be able to address. And, the answers to these questions that are stated as the policy of the international community need to be reflected in the actions taken in individual cases; and conversely. This point was emphasized by Peter Costello, the Treasurer (Finance Minister) of Australia in his remarks to the September 28 meeting of the IMF's International Monetary and Financial Committee:
"…what counts is what the Fund actually does rather than what it says it will do. Ultimately, it is the quality of the judgments that are taken in each case and whether the frameworks are applied consistently, which will determine whether the Fund is successful in helping to resolve crises. In effect, each decision will be part of the ongoing process of defining the role and success of the Fund. It is important that its actions are consistent with its stated intentions. This has not always been the case."
Indeed, I believe that this is part of the explanation of what went wrong in the misguided decision to expand IMF support to Argentina in August 2001—a decision that I have characterized as the worst single mistake of the IMF during the past decade. In December 2000, the IMF agreed, with the full participation of the outgoing US Administration, to a large international aid package for Argentina in order to provide the Argentine authorities with one last opportunity to avoid sovereign default and a disastrous economic and financial crisis. Everyone knew that there was significant risk that this effort might not succeed, especially if the Argentine authorities failed to carry through on their commitments to achieve moderate additional fiscal consolidation. But to those who saw large support packages as appropriate in some circumstances, the risks seem to be worth it, especially in view of the alternative.
With earlier large support packages, there had also been significant risks of failure, and some actual failures. Allowance for this possibility was made in how the packages were designed and/or implemented. In Mexico, in early 1995, the policies of the Mexican authorities initially proved inadequate to halt a collapse of confidence and catastrophic depreciation of the peso. Appropriate strengthening of these policies, backed by continued commitment of large-scale international support, was essential to achieve success. In Korea in December 1997, a rapid run-off of international bank credits threatened to overwhelm the government's modest reserves and available official financing, thereby forcing a catastrophic financial collapse. Facing up to this challenge, on Christmas eve, the policy strategy was changed; the major industrial countries moved to encourage their commercial banks to roll over their Korean exposures, with the backing of guarantees from the Korean government. The new strategy stemmed reserve losses and helped to reestablish stability. In Russia in the summer of 1998, the size of the initial IMF disbursement in a large official support package was cut back when the Duma failed to pass key legislation required under the IMF program, and the support package lapsed after the first disbursement when the Russian authorities defaulted and devalued. In Brazil in the autumn of 1998, a large official support package backed a stabilization program that, at the insistence of the Brazilian authorities, sought to preserve that country's crawling peg exchange rate regime. In view of substantial doubts about the viability of that exchange rate regime, however, the support package did not permit unlimited use of these resources to defend the exchange rate. When the policies of the Brazilian authorities proved inadequate to sustain market confidence, the exchange rate regime collapsed. As a condition for continued official support, Brazil then had to move to a floating exchange rate regime. Thus, in all of these cases where large support packages were used, the possibility of failure was recognized (at least implicitly), and approaches to deal with this possibility were considered and implemented.
In Argentina by the summer of 2001, it was clear that the stabilization effort was failing and there was no reasonable expectation that the Argentine authorities could implement policies to correct the situation. Without commitment of additional official support of at least $30 billion-something that the official community was not prepared to contemplate-sovereign default and collapse of Argentina's convertibility plan had become unavoidable. Understandably, the Argentine authorities were loath to recognize this fact. But, the leaders of the international community (at the IMF and in key finance ministries) should have known better. Augmenting the support package for Argentina and disbursing another $6 billion of IMF financing in early September 2001 was a stupidity. The collapse was merely postponed by a few weeks, Argentina was stuck with $6 billion more of official debt that it now finds very difficult to repay or reschedule, and potential opportunity to manage the inevitable collapse in a less catastrophic manner was lost.
To what extent did general disdain of senior US officials for large official support packages contribute to the serious mismanagement of this particular support package. It is difficult to know, especially because relatively limited practical inexperience with these issues probably also played a role. However, common sense suggests that those who are ideologically opposed to large international support packages are probably not very well prepared to manage them effectively. By analogy, while we do not want war mongers as our military leaders, a conscientious objector is not suitable as Commandant of the Marine Corps. If the United States endorses an international system that uses large packages of official support as part of the mechanism for dealing with emerging-market financial crises—as is implied by the actions of successive US Administrations-then the responsible US officials need to understand and appreciate both the uses and the limitations of this tool of international economic policy.
Uruguay and Brazil
Uruguay is a small country with a GDP of only about $20 billion, less than one-tenth the size of the Argentine economy and barely 3 percent of the size of the Brazilian economy.3 Because of its small size, I normally do not pay much attention to Uruguay. However, because of Uruguay's close economic linkages to Argentina (and to a lesser extent to Brazil), it was clear even to me that Uruguay was in for serious trouble (on top of an already ongoing recession) as Argentina's crisis deepened over the course of last year. This judgment was clearly shared by most of the relevant staff at the IMF. The report for the annual Article IV consultation with Uruguay (dated September 21, 2001) emphasizes that "…Uruguay is highly vulnerable to further shocks in the region." [emphasis in original] Nevertheless, nothing special was done last year to help Uruguay contend with the adverse spillovers that were obviously likely to come from Argentina, other than continuing with a modest IMF program (with support of about $200 million or about 50 percent of Uruguay's IMF quota spread over 22 months) that had been established in May 2000.
With the existing IMF program due to expire at end March 2002, negotiations for a new program were underway during the winter of 2002. They concluded with an agreement (approved by the IMF Executive Board on March 25, 2002) that committed about $750 million of IMF support spread over 2 years. This amount was almost at the upper limit of normal access for Uruguay to IMF resources. Nevertheless, I believe that the technical staff at the IMF understood from the start that this new program fell far short of what was likely to be needed to help Uruguay successfully confront its impending crisis-mainly but not exclusively the result of contagion from Argentina. Whatever might have been the views of the technical staff, however, the management of the Fund and the Fund's major shareholders were not, at this point, willing to contemplate yet another IMF program beyond the normal access limits.
A special characteristic of Uruguay is that it has a large banking system relative to the size of its economy, with assets of public and private banks amounting to about 50 percent of GDP. Most of the liabilities of the banking system are denominated in or indexed to the US dollar, and a substantial part of bank deposits is held by nonresidents (mainly Argentines). Banks maintain large foreign-exchange assets to offset their foreign-exchange liabilities, but are nevertheless exposed to considerable risk from sharp depreciation of the peso against the dollar. Uruguay also has a substantial public debt, and the ratio of public debt to GDP has risen rapidly since 1998 as the economy has been in recession and the government's fiscal position has deteriorated. The decision to double (to 15 percent per year) the rate of depreciation of the peso against the dollar in June 2001 was necessary in view of the deterioration in Uruguay's internal and external economic situation; but, as a portent of troubles to come, this did not ease concerns about the banking system or the rising public debt ratio.
In the spring of 2002, the problems latent in Uruguay's economic and financial situation began to deepen. Large outflows of bank deposits, including substantial outflows by nonresidents, put downward pressure on the exchange rate and rapidly ate into both the liquid foreign assets held by public and private banks and the central bank's foreign currency reserves. Facing huge reserve losses it soon became necessary to allow the peso to float (i.e., sink) against the dollar. By late May a new IMF mission was on its way to Uruguay with the announced intention of negotiating a substantial augmentation of IMF support. In mid-June Deputy Managing Director Eduardo Aninat announced that the IMF management would endorse an increase of IMF support for Uruguay of about $1.5 billion—bringing total committed IMF support to over 600 percent of Uruguay's IMF quota, more than double the normal cumulative access limit.
As most of the technical analysts suspected, even this large new commitment of IMF support was not enough to contain Uruguay's deepening crisis. In early August, IMF Managing Director Horst Kohler announced a further augmentation of IMF support committed to Uruguay—this time, about another $500 million. The World Bank and the Inter American Development Bank (IDB) would also chip in increases in their support, bringing total official support committed to Uruguay to $3.8 billion, or roughly one-fifth of Uruguay's GDP.
However, even at this stage, it is still unclear whether the large amount of official support will be enough to enable Uruguay to resolve its financial difficulties without a restructuring either of its public debt or of the assets and liabilities of most of its banking system. Indeed, despite repeated augmentations of its financial support, the international community has never really faced up to the fundamental questions of whether, and under what policies and conditions, Uruguay can successfully emerge from its present crisis without a comprehensive debt restructuring, or whether a comprehensive debt restructuring is not, in fact, an essential part of the solution of Uruguay's difficulties. Rather, the strategy seems to have been to throw more and more money at the problem in the hope that it will go away—perhaps with the recognition that what is a lot of money for Uruguay is not all that much from the perspective of the international community.
In summary, my view is that the performance of the international community in its efforts to assist Uruguay during the past nine months fell considerably short of the best that one might reasonably have expected. Tiny Uruguay was facing a major potential financial crisis—mainly reflecting contagion from Argentina. From the start, it was clear that moderate levels of official support, within normal access limits, would clearly not be adequate to forestall the crisis. Only massive official support or a very painful restructuring of Uruguay's public debt and financing system would do the job. The international community, however, was not prepared to face up to this choice. It dithered. As the crisis deepened, significant official support was pledged, but not enough to be entirely convincing. The result has been that large-scale support that might have been sufficient to resolve the problem if fully committed at the start has instead still left significant risk of further troubles.
Moreover, even with a record ratio of official support to GDP, it is still unclear whether the strategy will work for Uruguay, or whether a resolution involving comprehensive debt restructuring might be either better than what has been done and/or still necessary.
In the case of Brazil, I believe that the performance of the international community has been much better, notwithstanding important mistakes by the US authorities. Recognizing that Brazil might suffer adverse spillover effects from Argentina's crisis, a precautionary IMF program was established in September 2001. Under this program, Brazil progressively accumulated the right to draw up to about $15 billion of IMF resources, under the condition that it maintain a responsible fiscal policy (with a primary budget surplus of at least 3 1/2 percent of GDP). The objective was to reinforce confidence in Brazil's economic policies both by supplying an important supplement to Brazil's own foreign exchange reserves (of $30 billion to $40 billion) and by providing the monitoring of an IMF program to help assure that critical economic policies remained on track.
Nevertheless, there clearly remained a significant risk that a financial crisis might beset Brazil. To demonstrate that this risk was anticipated, not merely recognized in hindsight, I quote from my International Economics Policy Brief on "Prospects for the World Economy: From Global Recession to Global Recovery," released as PB02-2 by the Institute for International Economics in early April 2002.
"The major question for Latin America (aside from the uncertainties about Argentina) is the likely performance of the Brazilian economy—which accounts for 40 percent of Latin America's GDP…. The key question for Brazil is whether growth will reaccelerate as global growth recovers, or whether uncertainties arising from the October elections and spillovers from Argentina may provoke a crisis of confidence in the sustainability of Brazil's debt dynamics, leading to another economic downturn.
The fact is that, for an emerging-market country, Brazil has a relatively high ratio of public debt to GDP. Most of this debt is either quite short-term, has floating interest rates that adjust rapidly to movements in short-term market rates, is denominated in foreign currency, or has some combination of these features. This implies that if for any reason (including rising doubts about Brazil's ability to meet its debt service obligations), interest rates on Brazilian debt rise or the foreign exchange value of the real [Brazil's currency] falls, Brazil's debt service burden and/or the ratio of debt to GDP will rise—contributing to worries that debt dynamics may be unsustainable. Moreover, Brazil has a relatively small share of exports in GDP and, accordingly, is dependent on a continuing inflow of foreign capital to finance a significant current account deficit and also to finance a continuing rollover of substantial foreign indebtedness. Thus, apart from possible concerns about the stability of public sector debt dynamics, there are also potential concerns about the financing of Brazil's external payments. If confidence is lost in either of these key areas, a crisis would likely ensue…
As an optimist, I assume that the chances are three to one that Brazil will navigate through the difficulties of 2002 without a crisis…"
Unfortunately, this optimism was short-lived. During May, opinion polls began to show a significant lead for the Worker's Party presidential candidate, Luis Ignacio Lula da Silva (Lula) and relatively weak support for the candidate of the ruling coalition, Jose Serra. This provided a trigger for increased market concerns about what might happen in Brazil after the election. The interest rate spread on Brazilian Brady bonds, which had stood at about 700 basis points above US Treasuries in early April, began to rise and breached 1,000 basis points in June. The real came under downward pressure as foreign creditors began to cut back their Brazilian exposures and Brazilians scrambled for foreign exchange to meet debt service obligations and pay for the trade deficit.
During the summer, as Lula's poll results remained strong and Serra's results generally weakened, the crisis deepened, with interest rate spreads widening to 2,000 basis points and with the real sinking to well beyond 3 to the dollar (versus about 2.3 to the dollar at the start of the year). While shifting poll results clearly influenced these developments, the true underlying cause was the vulnerability in Brazil's public debt and external payments positions and the problem of "multiple equilibrium" that these vulnerabilities generated. John Williamson, my colleague at the IIE presents a very useful and insightful analysis of this problem in his International Economics Policy Brief, "Is Brazil Next?" issued as PB02-7 by the Institute for International Economics in August.
Under the general assumption that the Brazilian government continues to run a responsible fiscal policy with a primary budget surplus of 3 1/2 to 4 percent of GDP, there are two possible outcomes for Brazil's public debt dynamics: stable and unstable. If people believe that the debt dynamics are stable then the holders of Brazilian government debt (both domestic and foreign) will probably be satisfied with real interest rates on this debt of 7 to 8 percent. These would be very high real interest rates for an industrial country like the United States, but in line with what real interest rates have been in Brazil and in many other emerging-market countries. At this level of real interest rates, experience suggests that the Brazilian economy can grow in line with its potential—a real GDP growth rate of perhaps 4 percent. In this situation, starting with a public debt to GDP ratio of 60 percent, a primary budget surplus of 3 1/2 to 4 percent of GDP would be sufficient to put the debt to GDP ratio on a downward path. Thus, confidence that public debt dynamics are sustainable leads to the result that they will be sustainable.
On the other hand, if people believe that the Brazilian government cannot successfully manage its finances without restructuring the public debt, they will demand high real interest rates to compensate for the risk of the losses they will take in the event of a restructuring. At a real interest rate of 10 percent, with a debt to GDP ratio of 60 percent and a real GDP growth rate of 4 percent, it takes a primary budget surplus of 4 percent of GDP just to stabilize the debt to GDP ratio. At real interest rates above 10 percent, public debt dynamics are unstable (without an increase in the primary budget surplus). Higher real interest rates also reduce the likely growth rate of the Brazilian economy, which worsens prospects for debt sustainability. Most importantly, by making debt sustainability less likely, higher real interest rates promote even higher real interest rates in a vicious cycle. At present, interest rate spreads on Brazil's external foreign currency debt imply real interest rates above 20 percent.4 There is no doubt that these interest rates embody a very substantial premium for the risk that the Brazilian government may have to restructure its debt. If in coming months confidence is not somehow restored and interest rates are brought well below present levels, debt restructuring will become a self-fulfilling prophecy.
Of course, the preferred outcome from this multiple equilibrium situation would be for confidence in debt sustainability to produce that result (assuming that the Brazilian government continues to deliver a responsible fiscal policy). John Williamson and many others argue that this is the economically appropriate solution that the market should either naturally seek this solution or be pushed toward it. While I appreciate this position, I also tend to share the skepticism of one of my other IIE colleagues, Morris Goldstein.5 While sometimes fickle, the market is not completely nuts. After several years of large private capital inflows and official acclaim for its economic policies, Argentina has recently defaulted on a large volume of public debt. The situation in Brazil is in some respects (relatively high public debt and a high ratio of external liabilities to exports) similar to that in Argentina. And, despite recent official praise for Brazil's sound policies, the policy track record is not entirely reassuring.
In particular, during the eight-year tenure of President Cardoso, the net public debt to GDP ratio has risen from 30 percent to over 60 percent. In addition, the government has spent large privatization revenues. Part of the increase in net public debt is explained by the recognition of previous off-the-book losses or "skeletons" and, especially recently, by the sharp increase in the domestic burden of dollar-denominated or dollar-linked debt arising from the large depreciation of the real. But, not yet all of the skeletons have emerged; and the choice that the Brazilian government made to issue dollar-linked debt clearly involved substantial contingent liabilities that are now being manifest at a particularly embarrassing time. Thus, in Brazil, the market knows that it has something to worry about, and sweet talk is not going to be enough to persuade it otherwise.
What has the international community done to help Brazil in its deepening predicament? Having met the conditions for its September 2001 IMF program, in July Brazil exercised its accumulated rights to draw on IMF resources to the tune of about $14 billion. More importantly, the IMF agreed to a new stand-by arrangement (formally approved and announced on September 6, 2002) that committed about an additional $30 billion of IMF support to Brazil, subsequently supplemented by additional commitments from the World Bank and the IDB. The new IMF program provided only an additional $3 billion immediately and committed another $3 billion for potential disbursement before year end; and it reserved the remaining $24 billion for potential disbursement during 2003, conditional on the new Brazilian government maintaining responsible fiscal and monetary policies. The objective of the new IMF program was two-fold: to provide Brazil with some additional resources to help meet near-term market pressures (mainly by allowing Brazil to utilize an additional $10 billion of its own foreign exchange reserves); and to help restore market confidence by assuring significant additional IMF support based on continued sound policies.
Market reaction to the initial announcement of the new IMF program (in August) was positive, but this lasted for barely a day. Markets soon figured out that the new program had not significantly altered the fundamentals of Brazil's economic and financial situation nor the uncertainties associated with the upcoming election.
Nevertheless, I believe that this new program was the right approach in the circumstances. Unlike Argentina by the summer of 2001, the situation in Brazil is not (yet) hopeless; and comprehensive restructuring of Brazil's public debt and probably most of its private debt is not (yet) inevitable. The Brazilian elections (which will necessarily bring a change of government), however, are a critical barrier to taking the key decisions about what strategy to adopt to deal with Brazil's present predicament. The present Brazilian government is unwilling to contemplate debt restructuring because it sees it as unnecessary and highly destructive, and probably also because it realizes that restructuring would signal the failure of the policies of the past eight years. On the other hand, the present Brazilian government cannot credibly commit to policies that will remove the risk of restructuring; the responsibility for the design and implementation of such policies belongs to the next Brazilian government. That new government will not be determined until the elections are finished. Before the elections, no sensible candidate wants to contemplate and certainly not talk about the possibility of a debt restructuring. And, it is very difficult to be specific and credible concerning policies that may be needed to avoid restructuring when no one even wants to admit that such a terrible thing is possible.
In this situation, delay of critical decisions until after the Brazilian elections has been the only available and desirable option—even if such delay came at the cost of a few more billions of Brazil's dwindling foreign exchange reserves and some further shortening to the maturity of the government's debt. Once the elections are over, however, critical decisions will soon need to be made. In view of the calendar for debt refinancing, this cannot wait until the start of 2003 when the new Brazilian government formally takes power. Key members of the new economic team will need to be designated before mid-November. The new government-to-be will urgently need to begin to make clear the main elements of its policy approach, and will also need to begin to build political support to enact and implement the needed policies—as it prepares to assume office. The first few months in office then will become critical for establishing whether the new government will be successful in putting its policies in place and what, under these policies, Brazil's economic future will look like.
What are the relevant policy strategies for the new Brazilian government and what role should the international community play in supporting them? I believe that there are two distinct policy strategies worth considering, with the middle ground in between being essentially untenable.
Unfortunately, the untenable middle ground appears to be what is intended in the most recent IMF program for Brazil. As I understand it, this program envisions a respectable policy effort that would keep the primary budget surplus at just below 4 percent of GDP and maintain a monetary policy targeted at keeping inflation in the low single digits. There would be no effort to press the private sector, inside or outside of Brazil, to do anything special to support the stabilization effort. Official support would amount to the sums already committed by the IMF, World Bank and IDB. The problem is that the situation in one where restoring market confidence is the critical issue. The market is already well aware of existing IMF program, and the market clearly judges it to be inadequate—not just marginally inadequate, but very substantially inadequate. While it is possible that, after the elections, for some unforeseeable reason, there would be a large spontaneous recovery of market confidence, it seems foolhardy to base Brazil's economic strategy on this thin hope. The result is likely to be that after another $10 billion to $25 billion of official support is disbursed to Brazil and frittered away in vain efforts to avoid default, the collapse will come. Then, in a disorderly way, virtually denuded of reserves and of international support, Brazil will undertake a messier-than-necessary debt restructuring. Probably it will not be quite as bad; but it will look much like Argentina all over again.
On one side of this untenable middle ground is a basic policy strategy that recognizes that, because of highly negative market sentiment and limited ability of the Brazilian government and the international community to act sufficiently forcefully to substantially improve this sentiment, comprehensive debt restructuring is practically unavoidable. The effort would then be to manage this restructuring with as little damage as possible. This would be no easy task. The comprehensive debt restructuring would necessarily include both the Brazilian government's external and internal debt. In addition, the assets and liabilities of Brazil's financial system would probably need to be restructured, as would most of Brazil's private external debt. To accomplish all of this without profound damage to the Brazilian economy, as well as to Brazil's domestic and external creditors—as has happened in Argentina, would be a daunting task.
To complete this task with minimum unnecessary damage to all concerned will require continued sound fiscal and monetary policies. Use of already committed official financial support would also be important-but to help smooth out the inevitable difficulties of comprehensive debt restructuring, rather than blow it away in further futile efforts to delay a necessary restructuring. The result would probably still be a sharp negative shock to the economy (and to the government's public support); but if handled constructively, a comprehensive debt restructuring need not necessarily lead to a disaster of the magnitude of Argentina.
The other viable policy strategy is to adopt a vigorous, all-fronts effort to create a situation where comprehensive debt restructuring is not needed and clearly perceived as not needed. In my view, at a minimum, this requires that the Brazilian government credibly commit to fiscal policies that will raise the primary budget surplus to at least 5 percent of GDP (under reasonable economic assumptions) and maintain the surplus at this level at least until the debt to GDP ratio declines below 55 percent. A primary surplus of at least 4 percent of GDP should be maintained at least until the debt to GDP ratio declines below 50 percent. [The first objective could be met quite rapidly if the strategy is credible and appreciation of the real reduces the domestic currency value of Brazil's dollar and dollar-linked debt.] The policy strategy should also include responsible measures to persuade Brazilians both that they should be satisfied with reasonable real interest rates on the large volume of domestically held Brazilian government debt and that they should refrain from large-scale capital flight. Brazil's foreign creditors should also be officially encouraged-in their own self-interest and as their essential contribution to an ambitious stabilization effort-to behave responsibly in maintaining and restoring their credit exposures to credit-worthy customers. For its part, the official international community should pledge its continued financial support to Brazil-at a higher level than has already been committed, and clearly conditioned on stronger policy commitments from the Brazilian authorities and with some meaningful measures to assure constructive behavior by the private sector inside and outside Brazil.
How much additional official support might be contemplated? For a truly strong and credible stabilization effort with a good chance of success, it does not pay to be chintzy. Official support committed to Uruguay (which may not be enough) is at 20 percent of GDP. If official support for Turkey is augmented again next year (as I think likely), that too will rise to about 20 percent of GDP. For Brazil, official support at the level of 20 percent of GDP would amount to about $120 billion, somewhat more than double the substantial amount that has already been committed to Brazil. This sounds like—and is—a very large amount of money, reflecting the fact that Brazil has a large economy. Arguably a more modest commitment of official support, around $100 billion would be enough. But, in the business of large-scale official support packages, a key point to remember is that moderately large packages backing moderately strong programs tend to result in moderately large disbursements and program failures. Large support packages backing very strong programs are often not fully disbursed and generally lead to success. As General MacArthur observed about war, in the large package business, "There is no substitute for victory."
To be clear, I do not advocate war as the solution to all political differences among nations. Nor do I advocate large official financing packages as the answer to all potential and actual emerging market financial crises-including the crisis presently unfolding in Brazil. I raise the possibility of increasing official support for Brazil to the range of $100 billion to $120 billion primarily to dramatize a key point—directly relevant to the issues posed for this hearing. Consider the established policy, backed by the implicitly present U.S. Administration in the actions recently taken in the cases of a small country, Uruguay, and a moderately large country, Turkey. Apply this same policy consistently to a very large emerging-market country, Brazil. What do you get? A package of international support that is truly enormous!
Would it be a good idea to proceed with such an enormous support package for Brazil? Even someone who believes, as I do, that large international support packages are appropriate in some circumstances would be compelled to say, "Better think long and hard before doing that one."6 The general point is that similar careful thought ought to go into all cases where the potential scale of official support, relative to the size of the country, is quite large. The merits in all of these cases need to be weighed carefully because they set the policy of the international community. The approach adopted for a small country where large official support relative to the size of the country is comparatively modest in absolute terms sets a precedent for the approach that should be followed, in principle, for a much larger country where the absolute scale of official support could be enormous.
Consistent with the general policies that I believe should apply in such cases, I would recommend that commitment of substantial additional assistance to Brazil (or disbursement of much of the remainder of what has already been committed) should be undertaken only under tight conditionality. Specifically, the new Brazilian government must be prepared to commit to policies that raise substantially the likelihood that comprehensive debt restructuring can be avoided. The acid test that these policies be sufficiently forceful that they go a considerable distance toward restoring confidence in financial markets to a degree that induces a large reduction of interest rates without which fiscal sustainability is impossible.
It is far from clear that the new Brazilian government will want to, or be able to, undertake such policies. This would surely require backing off from key campaign pledges like hikes in minimum wages and large new public investment programs. It would require measures to cut public spending and/or raise revenues that would undoubtedly face fierce political opposition. But, the only other viable strategy-which will lead sooner or later to comprehensive debt restructuring—is also surely no bed of roses. The new Brazilian government will have to make some very tough choices—and quite quickly. Only if the government decides to pursue policies that provide the essential basis for a strategy that avoids comprehensive debt restructuring should the international community entertain the possibility of supporting this strategy with commitments of significant additional support. Brazil must not be another case, like Argentina, where large official support is disbursed and frittered away because the officials of the country and the officials of the IMF and its leading shareholders are not prepared to face up to reality and to their responsibilities.
Moreover, the international community, and especially the IMF, really cannot afford a big failure in Brazil. After the crises in Asia and Russia and the debacle in Argentina, the credibility of, and public support for, the IMF have been seriously damaged. Institutional recovery after another big failure would probably be very difficult.
Indeed, the IMF's own finances are a growing matter of concern. For many years, there have been a few countries that have fallen into prolonged arrears on their obligations to the IMF. But, the total amount of these arrears has remained relatively small. Now, in the aftermath of the Asian crisis, Indonesia is in a situation where it has a large amount of IMF credit (about $8 billion) and where there is some question about when it may be able to begin substantial net repayments to the Fund. For Argentina (with about $14 billion of IMF credit outstanding), the issue is more immediate—without an agreement on a new IMF program which effectively rolls over most of the large payments coming due during the next year, Argentina will probably be forced to go into arrears to the IMF and to the World Bank and the IDB. For Turkey, there is already a large volume of IMF credit outstanding, and the amount appears likely to continue to increase for some time and probably quite substantially. Where and when Turkey will get the resources to begin substantial repayments to the IMF remains an interesting question. For Uruguay, IMF credit already outstanding (now about $1.5 billion) is not that large in absolute amount, but if Uruguay became unable to make scheduled repayments to the IMF, this alone would about double the amount of IMF credit that is now formally in arrears.
If Brazil (which already has about $17 billion of IMF credit outstanding) were to go the way of Argentina, there might well be another large chunk of IMF lending that either goes into arrears or needs new programs just to roll over obligations to the IMF. And, if Brazil does follow this course, large further disbursements to Brazil in the near future will only make the problem of the IMF's finances that much worse.
In the long run, I doubt that countries like Indonesia, Argentina, Turkey, Uruguay, or Brazil will fail to repay their obligations to the IMF. But, there is still a rising risk that an important part of the IMF's resources will be tied up with a few countries that are unable to repay in a timely manner. This would seriously hamper the ability of the IMF to respond to the needs of other members and to play its proper and intended role in the international monetary and financial system. It would also contradict the letter and spirit of the IMF's Articles of Agreement. Members' use of IMF resources is supposed to be "temporary," and that IMF programs are supposed to contain adequate safeguards to assure that use of the IMF's resources is, in fact, temporary. If these principles are violated on a substantial scale, then the IMF is not fulfilling its important responsibilities, and those primarily responsible for its stewardship, both inside and outside of the institution, are failing in their primary responsibilities.
Sovereign Default and Debt Restructuring
One of the proposals for helping to deal with emerging-market financial crises, which has recently received much attention, is the suggestion of creating a sovereign debt restructuring mechanism (SDRM) through an amendment of the IMF's Articles of Agreement. An SDRM would provide an internationally approved set of procedures for a sovereign debtor in default (or potential default) on its obligations to reach an agreement with its creditors to restructure its obligations in a manner that would plausibly allow it to meet its new obligations while treating its various creditors in a responsible manner. Under such an SDRM, the existing rights of creditors to sue in national courts to seek recovery of their claims would be suppressed (at least for some period) and would be superseded by an agreement between a qualified majority of creditors and the sovereign on a debt restructuring.
Anne Krueger, the First Deputy Managing Director of the IMF, has been at the forefront of those suggesting that an SDRM is needed and desirable. A good deal of work on this issue has now been done by the IMF Staff, which is reported on the IMF's website at http://www.imf.org. The issue has been discussed by the IMF's Executive Board. At its meeting on September 28, 2002, the IMF ministerial committee, the International Monetary and Financial Committee, directed that work on this issue should continue with the objective of examining specific proposals at its meeting next April. The IMFC, however, has not endorsed the establishment of an SDRM. Beyond ministerial endorsement, establishment of an SDRM would require approval and ratification by members representing 85 percent of the voting power of the IMF—including formal ratification of an amendment to the Articles of Agreement by the US Congress.
It is essential to understand that present proposals for an SDRM would apply sovereign debt issued by all members of the IMF, but only to debt of sovereigns issued under foreign law. Sovereign debt issue under domestic law (which is the vast majority of sovereign debt, particularly for industrial countries like the United States) would not be covered. Official loans to sovereigns by other governments and by the international financial institutions would be excluded from the SDRM. The SDRM would also not apply to other (non-debt) obligations of the sovereign whether contracted under domestic or foreign law. Moreover, the SDRM would not apply to private debts or other contractual obligations, whether within a country or across national boundaries, regardless of the legal jurisdiction of the contract. These limitations are vitally important because they clearly imply that there are many important issues in typical emerging-market crises that an SDRM does not address at all.
Of course, one might consider a systemic restructuring mechanism (SRM) that would address the restructuring of all of a country's obligations, domestic and foreign, debt and non-debt, and public and private, regardless of questions of legal jurisdiction. Such a monstrosity, however, would be inconsistent with the most basic principle of the present international order—the principle that sovereign nations are responsible for the management of their own internal affairs. When a sovereign and its creditors chose to write their debt contracts subject to the law of another country, it is reasonable for that other country and for the international community to establish some rules for how defaults should be handled. It is quite another thing for the international community to assert the right to intervene in a sovereign's treatment of its domestic debt or into disputes among private contracting parties. This would imply extraordinary authority for the international community to intervene into the economic, financial, and legal affairs of sovereign nations, potentially including the overruling of national laws, court decisions, and even provisions of national constitutions.7 Most countries would rightly and strenuously object to such intrusions; and the international community would be exceedingly unwise to consider any mechanism that would systematically involve it in such intrusions. (As my colleague on this panel, Prof. Tarullo, is better qualified to discuss this particular issue, I will leave further comment to him.)
Arguably, an SDRM limited to the foreign-law debt of sovereigns would improve on present procedures for resolving sovereign defaults. Take the case of Argentina-which involves by far the largest default by an emerging-market sovereign on its foreign-law debt. Excluding bonds held by Argentine institutions (where the legal status is somewhat obscure), there the Argentine government has about $50 billion (face value) of foreign-law bonds outstanding, spread over more than 80 separate issues, and at least 5 different legal jurisdictions. Some of the bond issues have collective action clauses, which allow a qualified majority of bondholders to agree to a restructuring and impose its terms on all holders of that issue. Many of the bonds, however, follow US legal practice and require that each bondholder preserve the right to pursue legal action for collection unless he individually agrees to a restructuring. Clearly, resolving Argentina's sovereign default on its foreign-law debt will be a legal nightmare that is likely to take many years to conclude.
If it were applicable to Argentina, an SDRM along the lines that has been discussed within the IMF would help to cut through an important part of this legal nightmare.8 Existing legal requirements would be suppressed, and qualified majorities of the holders of all separate bond issues would be able to agree to restructurings of their particular issues. A qualified majority of the holders of all the bonds would (through means that I do not entirely understand) be able to agree to an overall restructuring. This would still leave difficult problems of actually reaching agreement within and between different groups of bondholders and between bondholders and the sovereign. But, individual bondholders and small groups of bondholders would have much less latitude than at present to disrupt an agreement and/or to stay out of an agreed restructuring in order to pursue their claims independently.
Granted that an SDRM might prove helpful in securing more orderly restructurings of sovereign foreign-law bonds when they fall into default, should creating an SDRM be a high order priority for reform of the international financial system? I have been, and I remain, highly skeptical. Whatever might be its advantages or disadvantages in resolving sovereign defaults, there is no credible reason to believe that an SDRM would meaningfully reduce either the likelihood of emerging-market financial crises or the severity of such crises when they occur.
Anyone who doubts the validity of this bald assertion should read carefully the literature on the SDRM (especially that recently produced at the IMF) to find the detailed analysis of how an SDRM would have materially reduced the frequency and severity of the many emerging-market financial crises that we have seen in the past decade. There is no such analysis. Instead, the sense of urgency for consideration of an SDRM has been built on two concerns: (1) existing legal procedures do not provide an orderly and reliable means for resolving sovereign defaults on their foreign-law bonds; and (2) there have been a lot of highly damaging emerging-market financial crises in recent years. But, is there any meaningful link between these concerns-a link that is absolutely essential to establish an urgent case for an SDRM? A little reflection on the facts clearly indicates that there is no such link.
Take the present crisis in Argentina. Among the major emerging-market financial crises of the past decade, this is the only case where sovereign default on a large volume of foreign-law debt has actually occurred. Undoubtedly Argentina is now undergoing a severe economic and financial crisis. Real GDP is down 15 percent from its year ago level and is down about 25 percent from its peak in 1998—the worst output drop suffered by Argentina in this century and surely one of the worst suffered in all of Latin America. But, what has the default of the Argentine sovereign on its foreign-law debt contributed to this catastrophe? And, what would an SDRM have done to lessen this damage? To both questions the answer is-practically nothing. Default on Argentine government debt held by Argentine banks has played some role in the collapse of the Argentine banking system, but this debt has effectively been transformed into domestic-law debt. As far as the sovereign's foreign-law debt is concerned, the Argentine government has simply stopped paying both interest and principal. Bondholders have complained. A few have filed suits in European courts; but, foreign courts have not authorized seizures of Argentine assets. More generally, actions by Argentina's disgruntled foreign bondholders have simply not played any significant role in Argentina's present economic disaster.
Down the road, of course, it is possible that difficulties in restructuring Argentina's foreign-law debt will create problems for the Argentine economy. When might these problems come and how severe might they be? No one can know for sure, but experience and common sense suggest that the problems probably will not come soon and, relative to Argentina's present difficulties, will likely not be that severe. In particular, the case that is cited as exemplary of the problems that can arise in the absence of an SDRM is the case of Elliot Associates versus Peru. In this case, many years after the Peruvian government had defaulted on some foreign-law bonds, a hold-out creditor was able to secure a court judgment enforcing payment under the original terms of the debt contract. This cost the Peruvian government some money, but it had no significant negative impact on the performance of the Peruvian economy. The example of Elliot Associates may encourage hold-out creditors in the case of Argentina; and this may delay and complicate negotiations over debt restructuring and ultimately cost the Argentine government some money. However, negotiations over debt restructuring will probably drag out for some time in any event, and payments to hold-out creditors are likely to be even further in the future-by which time the Argentine economy will hopefully have enjoyed substantial recovery.
Sovereign defaults on foreign-law debt have also occurred recently for some smaller emerging-market economies, notably Ecuador and Ukraine; and Pakistan has recently restructured much of its foreign-law debt. I am not an expert on these cases, but my general impression is that restructuring has proceeded relatively smoothly, despite the absence of an SDRM. A much larger and more complicated sovereign default, such as that of Argentina, might ultimately prove much more difficult to resolve. But, so far, fears about the extreme difficulties of sovereign debt restructuring in the absence of an SDRM, and especially about the great damage likely to be done to the countries involved, have not proved to be well founded.
Looking to the major emerging-market crises of the past decade, other than the present crisis in Argentina, sovereign default on foreign-law debt simply did not play a significant role.9 Specifically, in the Mexican crisis of 1995, the main problem was an overvalued exchange rate and difficulties in rolling over the tesobonos (domestic-law debt) and international credit lines to Mexican banks (private debts). In the Argentine crisis of 1995, sovereign default was not a serious risk. In Thailand's crisis of 1997-98, the problem was an overvalued exchange rate and actual or potential defaults on foreign credits extended to Thai financial institutions and corporations. In Indonesia, the problem was credits extended to Indonesian corporations by both foreign and domestic financial institutions. In Korea, the problem was an over-leveraged domestic corporate sector, weak banks, and international credits to Korean financial institutions. In Russia in 1998, lack of fiscal discipline led ultimately to default on the government's GKOs—domestic-law debt denominated in domestic currency—as well as widespread default by Russian banks on foreign-currency hedge contracts. In Brazil in 1998-99, doubts arose about fiscal sustainability, but default on the sovereign's (mainly domestic-law) debt was avoided. In Turkey since early 2001, there have been questions about debt sustainability for the government and the banking system; but most of the debt in question is domestic-law and/or private. The growing volume of official debt of Turkey, mainly to the IMF, would not be subject to an SDRM. In Brazil at present, there are worries both about fiscal sustainability and about external payments viability; but most government debt is domestic, and most external debt is private. In Uruguay at present (if this is considered a "major" emerging-market financial crisis), there are concerns about the sustainability of the public debt, which is mainly domestic-law debt; as well as with the stability of the domestic banking system which has a large volume of foreign-currency denominated liabilities. Thus, in all of these cases, it is hard to see that if an SDRM had been available it would have done much good; certainly it would not have been a magic bullet that would have avoided a crisis or substantially diminished its severity.
Even if an SDRM would do little good in dealing with potential or actual emerging-market financial crises, if it might occasionally do some good, is there reason to oppose it? Might it also do significant harm? There is at least some reason to be concerned with this possibility. Those who are most directly concerned with foreign-law debt of emerging-market sovereigns—the issuers of such debt, the investors in such debt, and the underwriters and brokers of such debt—generally oppose an SDRM. The issuers fear that their borrowing costs will go up because investors will demand higher rates to compensate for increased risks of losses from defaults under an SDRM. Investors object because they fear that their rights to recover when a sovereign defaults will be compromised and eroded by an SDRM. (Indeed, some are so fearful that they have chosen to embrace the more modest proposal of requiring collective action clauses in all emerging-market debt issues—provided that the "nuclear option" of an SDRM is abandoned.) The market makers fear that the volume and profitability of their business will decline under an SDRM. They all may well be right.
The argument on the other side is that market for foreign-law sovereign debt presently benefits from an implicit subsidy that leads to too much issuance of such debt, too much investment in such debt, and too much dealing in such debt. The implicit subsidy comes from the expectation that, if default threatens, the international community will step in with large packages of official support that will, to some meaningful extent, shield both the borrower and the investor from losses to which they otherwise would rightly have been subjected. Indeed, the principal supporters of proposals for an SDRM include particularly officials from those governments that are the major suppliers of the financing in official support packages. Many of these officials believe that there are huge problems of moral hazard arising from large official support packages, and they see an SDRM as a desirable innovation to help cut back on such packages.
On this controversy, I have a relatively neutral position—both sides are wrong. The fears that the market for emerging-market sovereign debt will be destroyed by a reasonably structured SDRM are probably exaggerated. Indeed, it is possible that a well-structured and competently implemented SDRM might improve the functioning of the market to the mutual benefit of issuers, investors, and dealers. On the other hand, concerns about substantial moral hazard arising from (properly implemented) international support packages have no analytical or factual foundation.10 And, as previously discussed, an SDRM would have little practical relevance to most emerging-market financial crisis.
What then should be done about an SDRM? For the present, I would recommend that it continue to be studied; but for two reasons, I would oppose its implementation. First, there is the general conservative principle that it is generally unwise to adopt potentially important innovations when a clear need for them has not been demonstrated and when the possible advantages and disadvantages are not well understood. The fact is that an SDRM would have done little to help reduce the likelihood or severity of past emerging-market financial crises. There is no reason to believe that an SDRM is urgently needed now.
Second, there is what I refer to as the "Elmer" principle. Elmer was the cat we had when I was a child about 50 years ago. For a feline, Elmer had a particularly affectionate and docile disposition—except when confronting other male cats, when he exhibited extreme hostility and aggression. In dealing with this latter problem, my father wisely advised, "It is usually a mistake to try to referee a cat fight. You are likely to be scratched and bitten; and your intervention is generally not appreciated by the principal participants."
A sovereign default on its foreign-law debt creates a situation analogous to an enormous catfight—only involving batteries of lawyers in addition to the primary participants. The interests of the debtor conflict with those of creditors as the debtor strives to pay less and creditors seek to collect more. The interests of different creditors conflict as each attempts to maximize his own return. The interests of other claimants on the sovereign resources (including holders of domestic-law debt) also come seriously into play; the more they get, the less is available for holders of the sovereign's foreign-law debt.
At present, the international community stands largely aloof from the fray, leaving it to the contending parties to work things out as best as they can.11 Under an SDRM, the international community would become a referee of the conflict—at least as far as establishing and attempting to enforce some general guidelines concerning the resolution of differences between the sovereign and holders of its foreign-law debt. Rightly or wrongly, the international community is likely to be accused by all parties of failing to treat their interests fairly, and is likely to be called upon by all parties to use its authority to support their particular interests. And, even if the international community could somehow determine what a "fair" resolution was, it would probably be unable to enforce it on all relevant parties—perhaps especially on the sovereign in default and on some of the domestic claimants on the sovereign's resources. It seems to me that the masters of the affairs of the international community would want to think long and hard before embarking on such a hazardous and probably thankless venture.
2. In large support packages, there has been greater reliance on IMF financing and less reliance on bilateral official financing than before 2001. In particular, there has been nothing similar to the $20 billion of bilateral official support that the US Treasury extended to Mexico in 1995-96. Nevertheless, looking at total commitments of official support (excluding the phony commitments in the so-called second lines of defense), the scale of recent commitments of official support, relative to any relevant standard, has been larger recently than in the past.
3. Large fluctuations of exchange rates over relatively short time periods can change dramatically the dollar value of the GDP of emerging-market countries. In the medium term, however, real exchange rates (i.e., exchange rates adjusted for movements in national price levels) are relatively stable. The dollar values of countries' GDPs referred to in this statement reflect what the GDP is at normal values of exchange rates when the economy is operating near its potential. For Argentina, GDP is about $250 billion, for Brazil it is about $600 billion, for Uruguay it is about $20 billion, and for Turkey, it is about $200 billion. In comparison, US GDP is about $10 trillion.
4. Real interest rates on Brazil's internal debt are significantly less than 20 percent. In particular, about half of the domestic debt is denominated in domestic currency and bears interest at a rate directly linked to the interbank overnight rate, the Selic rate. The central bank has been holding the Selic rate at 18 percent. With inflation now running at least 5 percent and probably headed upward, the real interest rate on the Selic linked domestic debt is in the range of 10 to 12 percent. But, without the imposition and effective implementation of stringent capital controls, the Central Bank will not be able to keep the Selic rate down at 18 percent if market interest rate spreads on Brazil's external dollar-denominated debt remain above 20 percent or even 15 percent. Indeed, the Brazilian government is already encountering difficulty in the auctions in which is seeks to roll over its (relatively short-maturity) Selic-linked debt. Eventually, if market determined real interest rates on Brazil's external debt remain very high, domestic real interest rate will rise to meet them.
5. Mr. Goldstein's analysis of Brazil's situation and the likely need for a comprehensive debt restructuring were presented in a public lecture, "Is a Debt Crisis Looming in Brazil?" at the Institute for International Economics on June 22, 2002. The main points are summarized in an op-ed column, "Brazil's Unwatched Borrowing," in the Financial Times, August 29, 2002.
6. IMF resources alone are probably not adequate to finance commitments of another $40 billion to $60 billion to Brazil. Even for the IMF's contribution, it would probably be necessary to activate the New Agreements to Borrow (NAB) under which the IMF can borrow additional resources from key members. Also, official bilateral contribution would probably be needed to finance a large augmentation of the package for Brazil. All of this, hopefully, would help to focus the minds of those who control the IMF on what they are trying to do and on the appropriate means for accomplishing it. The IMF should not shield high officials from their responsibility.
7. Under the conditionality associated with IMF programs, countries are often required to undertake policies requiring legislation or even constitutional modification. But, an IMF program is negotiated with a country's authorities who are free to reject the program and its conditionality if they so choose. An SRM that applied universally to IMF members, regardless of their wishes in individual cases, would represent a much greater infringement of the principle of national sovereignty.
8. A newly created SDRM probably could not be applied on an ex post basis to Argentina. But, consideration of how an SDRM would work in this case is very useful for consideration of what an SDRM might accomplish in cases where it would apply.
9. In arguing that an SDRM would probably be of limited practical use, Edwin Truman, my colleague at the IIE, has emphasized that most of the large emerging-market financial crises have not involved sovereign default of foreign-law debt as a major issue.
10. The assertion that there is a substantial problem of moral hazard arising from large international support packages is often advanced with great vehemence and conviction (for example, in the majority report of the Meltzer Commission) , but little evidence or rigorous analysis has been presented to back this assertion. Instead, like a principle of religious faith, proof is supplied primarily by loud and repeated incantation. Those who have analyzed the issue carefully generally conclude that this asserted problem of moral hazard, while not entirely bogus, has been much exaggerated. See, in particular, O. Jeanne and J. Zettelmeyer, "International Bailouts, Moral Hazard, and Conditionality," Economic Policy, 33, October 2001, pp. 409-31. I have also examined this issue quite extensively; see Mussa, et al., "Moderating Fluctuations in Capital Flows to Emerging Market Economies, in P. Kenen and A. Swoboda (eds.), Reforming the International Monetary and Financial System, International Monetary Fund,: Washington, D.C., 2000, pp. 75-142; M. Mussa, "Reforming the International Financial Architecture: Limiting Moral Hazard and Containing Real Hazard" in D. Gruen and L. Gower (eds.) Capital Blows and the International Financial System, Australia: McMillan Publishing Group, pp. 216-236; and M. Mussa, "Reflections on Moral Hazard and Private Sector Involvement in the Resolution of Emerging Market Financial Crises," paper presented to a conference at the Bank of England, July 2002.
11. The IMF's policy of "lending into arrears" does imply modest official sector involvement in the resolution of sovereign defaults on external debt—just as did the earlier IMF policy of not lending into arrears. Under the present policy, the IMF will, in some circumstances, lend to a country that is in default on its obligations to private external creditors—provided that the sovereign is making reasonable efforts to resolve the situation. This policy presumably gives the sovereign a little more leverage versus his creditors than did the earlier policy of not lending into arrears (which tended to give a little more leverage to creditors). The IMF's judgment about what constitutes a reasonable effort, however, is not intended to be used to influence in any detailed way how disputes between sovereigns and their external private creditors are resolved.
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Speech: Rescuing and Rebuilding the US Economy: A Progress Report July 17, 2009
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